May 19, 2011

David Lau on Ways to Enhance the Tax Efficient Frontier at NAPFA Session

Jefferson National's COO presents a tax deferral twist on Markowitz's efficient frontier at NAPFA Salt Lake

More On Tax Planning

from The Advisor's Professional Library
  • IRAs: In General Individual Retirement Accounts are highly popular tools for contributing funds that grow on a tax deferred basis. Depending on the type of IRA, the accumulation can be tax free.
  • Annuities: Variable Annuities Annuities are hot. The tax rules vary with the circumstances. Advisors must be aware of these intricacies when discussing annuities with clients.

A presentation by David Lau at the National Association of Personal Financial Planners annual conference in Salt Lake City on Thursday sought to explain the so-called tax efficient frontier, and advocate for maximizing its potential in client portfolios. Lau, chief operating officer with Jefferson National Life Insurance Co., said advisors can improve the tax efficient frontier through “the power of tax deferral.”

The concept, based on the notion of the efficient frontier (first defined by Dr. Harry Markowitz in 1952 in relation to modern portfolio theory), seeks to achieve optimal portfolio returns within a universe of risky investments.

“Tax deferral is an important part of wealth accumulation and portfolio optimization, not just from a risk/return standpoint, but from the standpoint of what’s left after the government taxes the investment gains,” Lau says.

Research published in June 2010 by the University of Chicago and Jefferson National found that tax deferral can potentially increase returns by as much as 100 basis points without increasing risk.

Why is something like that important, especially now, he asks? Most people think taxes will rise. When they will rise and by how much is still open to debate, but the Bush-era tax cuts will sunset at some point and it will affect every tax bracket.

“The tax efficient frontier seeks to identify those asset classes that can harness the power of tax deferral without raising risk,” Lau added. “It is a simple formula, one that holds tax efficiency equals after-tax total return divided by the pre-tax total return. What we’ve found is that tax deferral works especially well in increasing bond returns. Taxable bond funds gain 120 basis points in excess yield when placed within a tax-deferred wrapper.”

However, he noted the efficiencies of tax deferral take longer to reach with equity funds because equities are already tax efficient. From his analysis, it typically takes 22 years to reach the breakeven points for equity funds in a tax-deferred environment. As a result, he believes equity index funds work especially well in a taxable environment.

Before implementing a strategy that seeks to maximize the tax efficient frontier, advisors should ask themselves how long their clients will hold on to the portfolio and what asset classes they belong in.

“As I mentioned, the asset class with the shortest amount of time to a breakeven point is taxable bond fund,” he says. “The asset class with the longest amount of time to a breakeven point is a stock index fund.”

He then raised the question of whether or not variable annuities can increase tax efficiency. Typically, a barrier to tax efficiency has been their high fees, which cancel out any benefits tax deferral might bring. Research from Morningstar finds the average cost of a variable annuity is 135 basis points, more than negating the benefit of tax deferral.

“The solution is a low cost, no load variable annuity with a wide array of sub-account investment options,” Lau (left) said. “The advisor would be wise to put the equity portion in taxable accounts. For the tax inefficient, fixed income portion a low cost variable annuity makes sense for those who have maxed out their qualified accounts.”

He then concluded with key takeaways from the presentation:

  • The tax efficient frontier is achieved by holding assets classes in the most tax efficient location.
  • Asset classes like fixed income, REITs, commodities and actively managed funds perform better in a tax-deferred vehicle.
  • Tax deferral can increase returns without increasing risk.
  • Tax deferral is easy to implement and will work for most clients.
  • A new category of variable annuities is a key to success with the tax efficient frontier—especially for affluent clients. They include those that are low cost, have no-load and contain a wide array of investment choices.
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